1 Overview

After achieving a growth rate of 4.7

Table 1.1: Selected Economic Indicators
percent in FY16, the real GDP
growth target for FY17 was set at Q1-FY16 Q1-FY17P
5.7 percent. The higher growth is Growth rate (percent)
expected to be driven by a rebound LSMa 3.9 2.2
CPI (period average)1, a 1.7 3.9
in agriculture, and an enhanced
Private sector credit 2, b -0.6 -2.9
contribution from industry.
Money supply (M2)2, b 1.1 0.2
Exports a -14.3 -9.1
According to the preliminary data, Imports a -14.9 10.5
the real economic activities are Tax revenue (billion Rs) c 723.5 739.2
expected to maintain their Exchange rate (+app/-dep%)b -2.6 0.2
momentum. Specifically, the higher million US dollars
production of cotton, sugarcane and SBPs liq. reserves (end-period) b 15,245 18,491
maize crops is encouraging. Worker remittances b 4,966 4,698
Moreover, better supplies of minor FDI in Pakistan b 403 249
Current account balance b -579 -1,381
crops also signal some recovery in
percent of GDP
the agriculture growth.
Fiscal balanced -1.1 -1.3
P
Provisional estimate.
Regarding industrial activities, 1
YoY growth in the average of CPI index for the quarter.
though the performance of large- 2
Percent change in September over June.
scale manufacturing (LSM) has Sources: a Pakistan Bureau of Statistics; b State Bank of
Pakistan, c Federal Board of Revenue; and d Ministry of
remained subdued so far, we expect Finance.
the growth to gain some pace going
forward, on the back of supporting policies and encouraging outlook for automobile,
sugar, pharmaceuticals and construction-related sectors (see Chapter 2 for detail).

Notwithstanding the expected pickup in economic activities, the first quarter of FY17
experienced a widening of current account and fiscal deficits the two key
macroeconomic indicators which suggests that the underlying structural issues are
still there (see Table 1.1).
The State of Pakistans Economy

While the absence of inflows under Coalition Support Fund (CSF) in Q1-FY17 also
contributed to the rising current account deficit, the decline in remittances shows that
the FX comfort available to finance a persistently high trade deficit, is now
weakening.1 Moreover, the fall in exports entered in its 10th straight quarter in Q1-
FY17, and FDI inflows were also low.

The absence of CSF inflows (along with lower SBP profits) also led to a rise in the
fiscal deficit during Q1-FY17; but the underlying rigidity in the tax structure
continues to figure prominently. It is evident from lower than expected tax collection
during Q1-FY17.

While the role of well integrated and coherent trade and fiscal policies cannot be
overemphasized, the overall performance of the economy will depend on how the
private sector responds to the existing policy support offered by the government.
While the government has announced several fiscal incentives in the FY17 budget,
SBP has been maintaining a historic low interest rate. In this backdrop, the private
businesses have an opportunity to demonstrate that they can compete with their peers
in other emerging markets and contribute to the growth momentum of Pakistans
economy.

1.1 Economic review

The initial assessment indicates the economy is moving on its growth trajectory, amid
some challenges. In agriculture, sugarcane and maize harvests (accounting for 14.6
percent of the crop sector) are expected to reach record levels in FY17.2 Furthermore,
though the cotton production missed the target of 14.1 million bales by a significant
margin, it is still higher than the last years level.3

However, lower production of rice (compared to the last year) and a decline in sowing
area in the cotton belt of Punjab, raise some concerns. Specifically, rice production
has remained below last years level this was the third consecutive year when rice
recorded a YoY decline. Similarly, the shortfall in cotton production, when compared
to the target, is mainly due to a 20.8 percent decline in area under the crop in Punjab.
This in itself was the result of low cotton prices at the time of sowing, and the

1
Remittances declined by 5.4 percent in Q1-FY17 for the first time in four years.
2
The performance of minor crops also appears encouraging.
3
Cotton production is estimated at 10.5 million bales during the current year, compared with 9.9 million
bales last year.

2
 First Quarterly Report for FY17

exceptional losses last year due to pest infestation.4 We generally expect farmers to
switch to crops offering better prices (like sugarcane and wheat having price
security to a large extent); there are however reports of some growers having left their
fields fallow for this season.

LSM a major component of the industrial sector witnessed a significant slowdown

during Q1-FY17. This sluggish performance appears quite surprising given the
sustained growth noted in many of its sub-sectors (e.g., automobile, fertilizer,
pharmaceuticals and construction-related industries). A number of developments
explain this apparent disconnect. In the case of textiles, the largest subsector in LSM,
supply constraints (as cotton production remained low for the second consecutive
year) and continued weak demand from China and some advanced economies,
reduced the domestic production, particularly of low value added products (e.g., yarn
and cloth). The POL output, on the other hand, fell due to a policy shift to improve
the quality and standard of motor gasoline in the local market.5 Similarly, in order to
reduce tobacco consumption, the government substantially increased excise duty on
cigarettes in the FY17 federal budget, which in turn held back production. The lower
POL and cigarette production explains over one percentage point loss in LSM growth
this year.

It is expected that a better crop performance would provide a boost to wholesale and
retail trade the largest subsector in services. Within transport, storage and
communication, the merger of two leading telecom firms during Q1-FY17 is a major
development. Similarly, the exceptional growth in sales and import of both
commercial vehicles and petroleum products points to sustained economic activities in
the transportation sector. However, the performance of finance and insurance appears
less promising, as the impact of low interest rates is visible on the profitability of the
banking system. Specifically, the banking sector posted a profit of Rs 71 billion
during Q1-FY17, which was down 11.9 percent from last year.

Although the first quarter of the fiscal year coincides with seasonal credit retirement
to banks, the magnitude of this retirement was unusually large in Q1-FY17, due to: (1)
the exceptional rise in credit off-take during June 2016, which was retired next month

4
Cotton has strong forward linkages with the textile industry the largest exporting sector of the
economy.
5
Since most of the refineries were in the process of upgrading their infrastructure to produce higher
grade (Premier Motor Gasoline) PMG, this led to output decline during the interim period.

3
The State of Pakistans Economy

(in line with expectations); and (2) large corporates shied away from leveraging
further despite historic low interest rates, as they already have sufficient liquidity with
them. A positive development, however, was the higher loan demand for fixed
investment purposes, particularly for energy-related capital expenditures.

The heavy retirement by private businesses during July 2016, in turn, improved the
availability of funds in the interbank market. However, the major challenge for the
central bank, in terms of managing the SBP target rate, came when a record maturity
of PIBs (worth Rs 1.4 trillion) and Eid-related cash withdrawals, influenced liquidity
conditions in the market. A sizable volume of maturing injections under Open Market
Operations (OMO) in July 2016 provided a comfort as this absorbed inflows from
maturing PIBs. SBP effectively managed the interbank liquidity throughout the
quarter to ensure stability in the overnight rates, despite significant volatility in
interbank liquidity flows. This was also reflected in the stability of the 6-month
KIBOR a benchmark rate used by commercial banks and private businesses.

The first quarter also witnessed a shift in borrowing patterns of the government.
Specifically, the government made net retirement worth Rs 268.1 billion to
commercial banks, as opposed to net borrowing of Rs 443.8 billion in Q1-FY16.
Simultaneously, in order to meet its increased budgetary needs in the wake of a higher
fiscal deficit, the government resorted to SBP borrowings.6 This further reduced the
demand for funds available with commercial banks in the quarter. The resulting
increase in liquidity with banks led to a decline in the weighted average lending rates
of commercial banks.

The shift in government borrowings from SBP did not impact the reserve money, as it
was largely offset by the roll-back of OMO injections from the interbank market.7
The growth in overall money supply (M2) remained almost muted due to heavy
retirements under private sector credit.

In this backdrop, SBP adopted a cautious stance in its monetary policy reviews of
July, September and November, 2016, and kept the policy rate unchanged. SBP has
also been closely watching a gradual rise in CPI inflation and developments in the

6
In net terms, the government borrowed Rs 567.8 billion from SBP in Q1-FY17, which was quite
opposite to the net retirement of Rs 304.4 billion during Q1-FY16.
7
The outstanding volume of OMO injection fell from its peak of Rs 2 trillion in mid July 2016 to Rs 1.15
trillion by end-September 2016.

4
 First Quarterly Report for FY17

external sector, like falling exports, rising imports and declining remittances (see
Chapter 3 for detail).

Specifically, the average headline CPI inflation rose to 3.9 percent YoY in Q1-FY17,
against 1.7 percent in the corresponding period of FY16. While a part of the recovery
was expected as inflation had already dipped to ultra-lows last year, further impetus
came from supply-side factors.8 While trends in actual inflation were important, from
policy perspective, SBP was also closely tracking changes in inflationary expectations
in the economy. The Consumer Confidence Survey for September 2016 reflected
lower expectations about prices for the next six months.

The moderate inflation expectations were because of: (1) the government did not
increase petroleum prices and power tariffs, despite an increase in global oil prices;
and (2) the exchange rate an important anchor for inflation expectations remained
stable during the quarter. The stability in the exchange rate, in turn, came on the back
of healthy financial inflows. These inflows not only covered a worsening current
account and declining foreign investment, but also led to a buildup in foreign
exchange reserves for the 8th consecutive quarter.

As mentioned earlier, the current account mainly weakened in Q1-FY17 due to

absence of CSF inflows. Further pressure came from a widening trade deficit (with
rising imports and declining exports) and a fall in remittances (the first such decline in
the past 14 quarters).9

Focusing on imports, the non-oil import bill increased sharply during Q1-FY17,
mainly due to higher import of machinery (power generation, electrical and
construction) on the back of CPEC-related activities. The overall imports, however,
benefited from a significant decline in oil payments during the quarter.10 This
highlights the exposure of the countrys external sector to global commodity prices.

8
These include a gradual rise in international prices of some key commodities (e.g., palm and soybean
oil, crude oil, sugar, cotton, iron, coal, copper); increase in taxes by the government; and measures to
control informal trade on both eastern and western borders of the country.
9
To put this in perspective, the Q1-FY17 current account deficit more than doubled to US$ 1.4 billion
from the level recorded in Q1-FY16, whereas FDI inflows dropped by 38.2 percent to US$ 249 million
during the quarter.
10
According to BoP data, the non-oil imports increased by US$ 494 million, whereas oil imports fell by
US$ 364 million.

5
The State of Pakistans Economy

Hence, the recent gradual recovery in international prices of crude oil becomes a
concern, given that non-oil imports are already expected to remain high, considering
the priority attached to CPEC projects. It is, therefore, important that CPEC-related
projects continue at their scheduled pace, so that associated inflows from China is
available to offset the rise in the import bill.

Ideally, a countrys rising imports should be funded through export earnings (and
other non-debt creating inflows, like, remittances and FDI). However, in our case,
exports are almost half of imports, and have been on a declining path for over two
years now. Reversing the downtrend in exports has become more daunting due to
continued soft demand in traditional export markets (particularly China) and rising
popularity of anti-trade sentiments, mainly in developed economies.

For the past several years, the country had been relying on remittances to fund the
widening trade deficit. During Q1-FY17, remittances, however, recorded a decline
for the first time in four years. Though the decline was partly due to a seasonal (Eid)
factor which had inflated personal transfers in June 2016 and then led to a big drop
in the following month other impediments (like fiscal consolidation in the GCC and
a constricting environment for global correspondent banking) were also in play.

In this situation, official inflows not only financed the current account deficit, but also
led to a buildup of FX reserves. Increased loan disbursements, particularly from
China, more than offset the decline in investment inflows. This change probably
reflects a broader shift in the nature of inflows from China: while investment flows
dominated Q1-FY16, long-term loan disbursements were the leading component this
year.

Thus, the external debt of public sector increased by US$ 1.0 billion and reached US$
58.8 billion by end-September 2016. As mentioned earlier, this rise came mainly due
to long-term commercial loans of US$ 700 million (from China). The government
also made a net retirement of US$ 315 million short-term commercial loans during the
quarter. The substitution of short-term loans with long-term debt would improve the
maturity profile of the external debt.

The overall stock of public debt increased by Rs 866.1 billion in Q1-FY17, with over
85 percent of the incremental debt contributed by government borrowings from
domestic sources. While a part of this additional debt funded the fiscal deficit of Rs

6
 First Quarterly Report for FY17

438 billion for Q1-FY17, the rest of the amount led to a buildup of government
deposits with the banking system. Moreover, the maturity of a significant volume of
PIBs in July 2016, along with the large issuance of short-term debt, shortened the
maturity profile of the domestic public debt.

In terms of GDP, the fiscal deficit reached 1.3 percent in Q1-FY17 the highest first-
quarter level since FY12. More importantly, the deficit increased despite an
exceptional growth in provincial surpluses. The major drag came from a sharp
decline in non-tax revenues (mainly due to the absence of CSF inflows, drop in
dividends from public sector enterprises, and lower profit from SBP).11 The tax
revenues also remained well below expectations.12 On the expenditure side, the
government was more prudent, as current spending registered a marginal decline.
Development expenditures, on the other hand, increased by 12.4 percent in Q1-FY17
on YoY basis, on top of the 47.4 percent rise recorded in Q1-FY16.

A number of incentives offered by the government to encourage new investments led

to a decline in direct tax collection. Indirect taxes, on the other hand, recovered
sharply during the quarter following the rationalization of tariff slabs, increase in
customs duty for certain slabs, and higher import volumes. The turnaround in sales
tax collection is worth mentioning as it was realized despite a lower effective tax on
petroleum products.13

Meanwhile, the government has been able to contain current expenses due to lower
spending on subsidies. Interest payments, however, remained unchanged as the gains
realized from low interest rates were largely offset by an accumulation of public debt
stock. On the other hand, the strong growth in development expenditure during the
quarter was led by the provinces, as federal development spending posted a YoY
decline of 7.6 percent in Q1-FY17. Most of the spending by provinces went to
infrastructure improvement, followed by health and education.

11
The low oil prices reduced the profitability of PSEs in the energy sector. SBP profits declined due to
falling interest rates and lower stock of government debt with the central bank. The outstanding stock of
government borrowing from SBP (on cash basis) fell from an average of Rs 2.1 trillion in FY15 to Rs 1.6
trillion during FY16.
12
The government normally collects 20 percent of the annual revenue target during the first quarter. In
Q1-FY17, tax collection reached only 16 percent of the revenue target of the full year.
13
The government absorbed the steady rise in global oil prices, and kept domestic petroleum prices
unchanged during Q1-FY17.

7
The State of Pakistans Economy

1.3 Outlook for FY17

As mentioned earlier, the GDP growth is expected to strengthen further during the
year. While the cotton crop missed its target by a significant margin, an increase of
6.3 percent in its production would still translate into higher growth for agriculture.
Furthermore, the improved performance of sugarcane and maize; better supply
situation of fruits and vegetables; and steady increase in the global prices of cotton
and sugar, are key positives for growth outlook. However, the performance of the
upcoming wheat crop (which contributes over 40 percent of the value addition by the
major crops) would be an important determinant of agriculture performance during
FY17.

The LSM growth so far is fairly low Table 1.2: Key Macroeconomic Targets and Projections
compared to last year. However, FY17
we expect some pick up in its pace 1
FY16 Target Projection2
on the back of continued supportive
policies, like low interest rates, percent growth
reduced cost of energy with Real GDP 4.74 5.7 5.0 6.0
improved availability, strong CPI (average) 2.94 6.0 4.5 5.5
domestic demand, healthy corporate billion US$
margins, and a conducive Remittances 19.92 20.2 19.5 20.5
investment environment. Some Exports (fob) 22.0 2
24.7 21.5 22.5
sector-specific developments are Imports (fob) 40.32 45.2 42.0 43.0
also worth noting. For example, a percent of GDP
better sugarcane crop and the recent Fiscal deficit 4.63 3.83 4.0 5.0
surge in international sugar prices Current a/c
would result in higher sugar deficit 1.22 1.5 1.0 2.0
14 1. 2.
production; the increased pace of Sources: Planning Commission; State Bank of Pakistan;
3.
Ministry of Finance; 4. Pakistan Bureau of Statistics.
work on infrastructure and CPEC-
related projects would boost the demand for cement and steel products; and the launch
of a new model of passenger car by Honda this year would partially compensate for
the lowering of sales after Apna Rozgar scheme (which was ended last year).
Furthermore, the recent recovery in cotton prices would likely benefit the domestic
textile industry (which has a sizeable share in LSM).

14
The liquidity position of sugar mills would ease as the higher prices make sugar exports feasible.

8
 First Quarterly Report for FY17

The expected recovery in LSM would also have strong spillover impact on wholesale
and retail trade, which is one of the major subsectors under services. Similarly,
transport sector is likely to perform well due to CPEC related activities.

In the case of inflation, an uptick was already expected in FY17. The recent revival of
global oil prices after OPECs agreement on oil supply may lead to higher non-food
inflation. On the other hand, food inflation may remain in check as the current stocks
of staple food (wheat and rice) seem sufficient. On balance, therefore, the inflation is
expected to remain within the target for the year (Table 1.2).

Given the revenue shortfall during Q1-FY17, achieving the annual fiscal deficit target
of 3.8 percent of GDP would be challenging. It will require additional fiscal
consolidation efforts on the part of the government.

We expect the current account deficit to remain in the range of 1-2 percent of GDP in
FY17, which is higher than the earlier forecasts.15 The outlook on remittances has
been marginally lowered, as the expected recovery in inflows from the seasonal
slowdown in July 2016 has not materialized yet. Furthermore, remittances from the
GCC countries (which contributed over 60 percent of total remittances) have declined
on YoY basis during Jul-Nov FY17, due to fiscal consolidation measures being
undertaken in the region. Similarly, remittances from the UK fell mainly due to the
sharp depreciation of the pound against the US dollar following Brexit.16 The
downward revision in export growth projections has come on the back of renewed
concerns about demand conditions in advanced economies; and a further weakening
of export prices for basmati rice.17

15
Earlier forecast for current account deficit was in the range of 0.5 1.5 percent of GDP, as reported in
SBP Annual Report, FY16.
16
Consequently, the US dollar-value of remittances from the UK is now lower for the same volume of
remittances expressed in pound sterling.
17
On a positive note, exports recorded a positive growth in both October and November 2016, suggesting
that the declining trend has finally bottomed out.